Due to the rally that we have seen in the market, many stocks & ETFs have become extended and overbought, with many now a good distance from a viable stop or support level. Because of this, the risk to enter an extended stock can be much greater than the potential reward. Please realize, in keeping with my disciplined risk management, that it is essential to your portfolio's health that I conduct a risk-reward analysis on each stock & ETF we choose to buy. Below, I have laid out this process for you.
Risk-Reward is just what the name implies; it is the process of evaluating how much risk you will take on, compared to how much reward you can expect to have on any given investment. Or said another way, how many points could the stock fall if the trade doesn't work out, versus how many points could you expect to see should the investment in fact go in our favor. Typically when evaluating Risk-Reward, we like to see a 2 to 1 ratio, at a minimum. In other words, for every point at risk, we want to have 2 points potential reward. So as the above sentences suggest, I need to be able to figure out what is the expected reward, and what is the potential risk. How do I calculate whether we should buy a stock or ETF at the current level, or wait for a pullback in price?
- Determine where significant resistance lies (ahead), or where the stock would be overbought on its trading band.
- Determine where significant support resides (below).
Calculate the price objective for the stock. - Determine a stop loss point - where the stock will break a significant bottom or trendline - basically, a point at which we no longer want to own the stock.
I also want to mention that market and sector risk should not be ignored; of course, I want to narrow the list of potential buy candidates down by focusing on strong stocks in strong sectors.
Following, is an example of evaluating risk-reward using BJ Services (BJS), which is a member of the currently favored - Oil Service Sector.
Buying BJS at Current Level (15.50):
This stock has broken out of a base of consolidation and has run straight up from $11 to $15.50. This rally has taken the stock right up to the top of its weekly distribution where the stock is considered to be 100% overbought. This suggests a pullback could be in the offing. Such a pullback would be welcomed from a risk-reward standpoint.
Risk-Reward Calculation:
Current Price = $15.50
Price Objective = $20.50
Stop Loss Point = $10.50
Reward = 5.00 points (20.50 price objective – 15.50)
Risk = 5.00 (15.50 – 10.50 stop loss)
Risk-Reward = 1 to 1 (5.00 / 5.00)
So as the calculation above suggests, the current risk-reward ratio is 1 to 1, meaning for every 1 point of risk, there is 1 point reward. This is insufficient, as I typically like to have at least a 2 to 1 ratio. Now let’s look at how the risk-reward parameters change if we wait for a pullback.
Buying BJS on a Pullback:
Let’s assume the stock simply pulled back to $13, which is now an area of support on the chart. Also, the middle of the ten week trading band is at $11.
Risk-Reward Calculation:
Current Price = $13.00
Price Objective = $20.50
Stop Loss Point = $10.50
Reward = 7.50 points (20.50 price objective – 13.00)
Risk = 2.50 (13.00 – 10.50 stop loss)
Risk-Reward = 3 to 1 (7.50 / 2.50)
Note that if you wait to buy BJS on a pullback to 13 the risk-reward ratio jumps above the acceptable 2 to 1 as the risk-reward improves to a 3 to 1 ratio, assuming a stop-loss of 10.50. This means that for every 1 point of risk there is a potential for 3 points of reward. In summary, by waiting for a pullback, it greatly improves the “Reward," and reduces the “Risk” and suggest that you don't chase stocks here, but instead be patient and let them pullback so that we have a reasonable risk-reward working to our advantage.
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